Short Strangles and Portfolio Margin, A Death Trap?

Customer Portfolio Margin (CPM)

What is CPM?  CPM is a margin methodology in which the margins are supposed to be based on risk.  The standard risk model used to calculate these risk-based margins is called the TIMS (Theoretical Intermarket Margin System).  TIMS was developed by the OCC (Options Clearing Corporation).

Interestingly, one method used by the TIMS to calculate margins assumes that the volatility of the underlying will remain constant.  This methodology could mean a disaster for short strangle traders.

Margin Expansion on Short Strangles

Many option traders qualify for a CPM account, but they do not understand how the TIMS risk model works.  Brokers make it very easy for clients to obtain this type of account, and traders are not typically tested on how it calculates margins.

This puts traders in a dangerous situation, especially when trading short strangles.  Let’s consider the following scenario:

A trader has an account value of $200,000.  This trader invests 50% of their buying power into short strangles (you’d be surprised how common this is).  Then suddenly, the underlying drops 10% quickly and volatility shoots way up.  Since the short strangle comprises -Vomma, -Vega and -Gamma, the margins could quickly double.  Now, the margin requirement jumps to $200,000, but at the same time, the trader experiences unrealized losses of $50,000, so their account value falls to $150,000.

This scenario means the trader now has a $50,000 margin call.  The broker liquidates the trader’s positions and loses another $50,000 during liquidation on the trader’s account.

This sounds like a nightmare, but it happens quite often.

Trading CPM Effectively

In order to trade a CPM account successfully, one has to understand how the risk model calculates margins, and one needs to design trades around this model.  Risk must be reduced by constructing proper dynamically hedged Vega positions, and Gamma must be designed carefully as well.  A lot of thought and planning must go into a trading system, so it works smoothly with CPM margins.

Traders who do not understand the TIMS model run into serious problems.  With proper training, CPM can be very rewarding, but without it, a trader’s success is not likely to ever become realized.

1. Stabilize margins through intelligent design.
2. Stabilize margins through effective use of vomma, vanna and vega.
3. Stabilize margins through better gamma management.
4. Stabilize margins through insurance against serious market declines.
5. Stabilize margins through understanding the TIMS margin calculations.
6. Increase probabilities by design and sophisticated adjustment processes.
7. Capture volatility skews that are entirely invisible to other traders.
8. Make effective use of Lambda.